Sorting through the ethanol hype
VeraSun and other producers going public are generating heat, but market analysts say retail investors should tread with caution.
NEW YORK (CNNMoney.com) - The buzz surrounding ethanol producers is growing as the first of three companies gets set to go public, but analysts say retail investors should beware of the risks associated with getting in on the ethanol game.
Wall Street has taken a shine to ethanol producers as sky-high crude prices, limited refining capacity and concerns over environmental pollution have helped push ethanol prices to record highs. Ethanol, an alternative fuel most often made from corn, is usually blended with gasoline to make it burn more cleanly.
Three ethanol producers are looking to capitalize on those conditions. VeraSun Energy, the nation's No. 2 ethanol producer,will list on the New York Stock Exchange under the ticker "VSE" Wednesday. Rivals Hawkeye Holdings and Aventine Renewable Energy have filed to go public as well.
Investors may be itching to take a ride the ethanol wave, but some of the challenges potentially facing the industry - the biggest being forecasts that profits may get squeezed - may give long-term investors reason to pause, analysts said.
"You couldn't find a better time to do an IPO because margins are probably at the highest they'll ever be," said Michael Judd, an ethanol analyst at Greenwich Consultants. "That's great in terms of raising money for the company, but I don't see why that's good for investors," he said.
Investors have expressed unabashed enthusiasm for ethanol companies - even those that aren't producing any supply. Shares of Pacific Ethanol (Research) have more than doubled so far this year, and the firm's first plant isn't even expected to go into operation until the fourth quarter.
It's no surprise then that the ethanol firms on deck, which have strong production capabilities, are generating plenty of attention.
VeraSun, which produces 230 million gallons a year, or about 5 percent of the nation's total production capacity, offered 18.25 million shares at $23 a share Tuesday, above the already bumped-up estimated price of $21 to $22 a share.
Compared to firms like Pacific Ethanol, the estimated price for VeraSun looks favorable, according to Bill Simpson of Trading IPOs.com. But even he cautioned that profit margins in the ethanol industry are likely to contract in the next year as more production comes online.
Demand for ethanol has surged as several states have banned or significantly regulated the use of MTBE, a gasoline additive suspected of causing cancer, and refiners have turned to ethanol as an alternative.
Rising demand, along with problems bringing products to market, have jacked up ethanol prices. New York Harbor spot ethanol prices are as high as $4.25 a gallon, up from about $1.85 at the start of the year, according to Jim Jordan & Associates, a research firm that tracks the ethanol fuel industry.
Consumer prices are likely to fall as these logistical issues are resolved, according to Cristoph Berg, an ethanol analyst with FO Licht, a commodities research firm. "Once these problems are addressed, the exuberance we see at the moment in the ethanol market might become more sober," he said.
Furthermore, production in the United States is brimming. According to the Renewable Fuels Association, a trade association for the nation's ethanol industry, annual production totaled 3.9 billion gallons last year, up 15 percent from 2004. Plants to produce another 1.9 billion gallons a year are under construction.
"There's a lot of capacity coming online, and by the end of 2007, it's going to explode," Simpson from Trading IPOs said. "There's the chance that 2006 could be the peak margin period for ethanol producers."
VeraSun reported net income of $2.7 million for the quarter ended March 31, up 58.8 percent from a year earlier. Hawkeye and Aventine also posted bumper profits in their most recent quarters, according to their IPO filings. But lower margins could cause earnings growth to evaporate, or at least slow down quite a bit, analysts said.
Furthermore, since ethanol is a commodity, managing risk poses an additional challenge to investors, Judd from Greenwich Consultants said. Fuel markets tend to be highly unpredictable, and ethanol usually is made from corn, another volatile commodity.
Still, Berg thinks it's too early to say whether shares in the ethanol market are overvalued.
"This is a new game. It might take another six to nine months to get a better picture of the real opportunities in the market," he said.
Related: Even bullish investors wary of ethanol.